July 30, 2004
The Top Ten Reasons Why Hedge Funds Dont Need Increased SEC Oversight
Keith H. Black, CFA, CAIA
The SEC has proposed that hedge fund advisers with 15 or more clients and 25 million in assets should register as investment advisers. This would allow the SEC to oversee their activities, comment on their pricing policies, watch their trading strategies, and to spot or prevent fraudulent activities in their earliest stages. There are a number of reasons why this proposed regulation may be misguided.
10. Hedge funds provide benefits to the markets, and enhanced regulation could stunt the growth of hedge funds. The benefits of hedge funds are numerous and well-documented. First, hedge funds trade very frequently, providing enormous liquidity to the markets. Should the growth or activity of hedge funds decline, trading costs for other investors would increase. Second, hedge funds make their living by making markets more efficient. If the short-selling influence of hedge funds is curbed, more securities may become overvalued, perhaps leading to another period of a stock market bubble and a subsequent crash.
9. There are loopholes in the registration requirements. In the current proposal, private equity funds are exempt from regulation because they require a lock-up period in excess of two years. While investors may be willing to invest in a venture capital fund for a minimum of two years, hedge fund investors are less likely to agree to this restriction. Some market participants predict that large hedge funds may increase their lock-up periods to two years, or longer, to escape the registration requirement.
8. Many hedge funds would not be subject to registration. Van Hedge estimates that that the median hedge fund manages only 33 million in assets. Fully 45 of hedge funds manage less than 25 million, and would be exempt from the registration requirements. While the smallest firms may be less able to deal with the increased cost of regulation, having thousands of unregistered managers reduces the deterrent effect of this policy.
7. The call for registration is far from unanimous. The SEC vote was a split 3-2, meaning that 2 of the SEC commissioners dont approve of the registration requirements in the current format. Others opposing the proposed requirements include Alan Greenspan and the chair of the Commodity Futures Trading Commission.
6. The SEC is inconsistent in their regulatory approach. The Commission recently decided to remove short selling restrictions from the 1,000 US stocks with the largest trading volume. This change in trading rules increases the returns, opportunity, and presumably the volume, of short sellers. While encouraging short selling with one regulatory change, the proposed rule may discourage the formation and trading activity of hedge funds, the largest source of short selling activity.
5. The proposed regulation requires that each registered fund hire a compliance officer. Many hedge funds run a very sparse shop, where some funds managing over 100 million in assets have less than five employees. The addition of a compliance officer will significantly raise the costs of the fund, which may necessitate an increase in fees paid by investors. It may also be difficult to hire over 1,000 new compliance officers on short notice, as there may not be enough competent and trained overseers to immediately step into this role.
4. Hedge funds are already regulated in many other ways. All traders in the markets, whether registered or not, have a myriad of regulations to follow. No one is immune from the regulations regarding insider trading, fraud, and market manipulation. Funds that trade futures are already regulated by the NFA and the CFTC. Surprisingly, the most effective regulator of hedge fund advisers today is not a governmental agency, but the community of pension fund and endowment managers. Nearly 40 of hedge fund advisers have already voluntarily registered as investment advisers. Because institutional investors are very careful about their due diligence, they typically only allocate assets to the funds with the best risk management systems, most robust legal and regulatory structure, and the most transparency. The market has made it clear that secretive funds with a dubious legal structure typically are not able to attract large amounts of assets.
3. The SEC is already dangerously short of resources, as their enforcement staff is unable to detect clear abuses in very large markets. The highly regulated mutual fund industry manages 7.5 trillion for over 95 million US investors. The enforcement staff of the SEC was not the first to discover the market timing abuses, as they were scooped by the New York Attorney General Eliot Spitzer. This trading strategy was far from obscure, as it had been published in a number of academic journals. While unregulated hedge funds were certainly willing participants in the mutual fund market timing and late trading scandals, each case had a willing accomplice in the form of the regulated and registered banks and mutual fund managers. The hedge fund community is much smaller, managing less than 900 billion for less than 3 million investors worldwide. Those eligible to invest in hedge funds in the US must have a net worth exceeding 1 million, which assumes that they can afford the best advisers and can stomach losses from unregulated investments. If the registration requirement also applies to hedge fund advisers in foreign countries that do business with American investors, we run the risk of conflicting regulations and competing regulatory regimes. In contrast, the typical mutual fund investor is much less sophisticated, and who may need increased oversight to prevent the loss of their average investment of only 48,000. Perhaps the SEC should make sure that the mutual fund industry is sound before they add the burden of thousands of smaller hedge fund managers.
2. The incidence of fraud is miniscule in the hedge fund community relative to fraud in the mutual fund and equity markets, which are already highly regulated by the SEC. In their presentation on hedge fund fraud, the SEC stated that 46 hedge funds have been prosecuted for fraud, with a cost to investors of 1 billion. Mutual fund firms have already committed to pay nearly 2.5 billion in fines, penalties and fee givebacks for their part in the market timing and late trading scandals. Fraud is even larger in the equity markets. Not only did Enron lose 68 billion of equity market capital for their stock investors, their creditors will also write off in excess of 50 billion. This is not to mention the billions lost at WorldCom, Adelphia, HealthSouth, et. al.
1. SEC regulation has not been able to deter past frauds, even among regulated entities. It is clear that fraud has been perpetrated at a wide variety of regulated companies and mutual fund management firms. How will registration of hedge fund advisers reduce fraud by these managers? Of the 46 fraud cases brought by the SEC against hedge funds, eight of these were against managers who had previously registered as investment advisers, while twenty were against managers who would not be required to register under the proposal given their minimal assets under management. If only 40 of the hedge fund fraud cases were prosecuted against advisers that would be newly registered as proposed under this act, it is clear that registration will not be an effective deterrent against future fraud cases.
Keith H. Black, CFA, CAIA is the author of Managing a Hedge Fund: A Complete Guide to Trading, Business Strategies, Risk Management and Regulations. He teaches a course on hedge funds for the Stuart Graduate School of Business at the Illinois Institute of Technology.